Preparing for Solvency II – Theoretical and Practical issues in Building Internal Economic Capital Models Using Nested Stochastic Projections

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Marc Slutzky~Ed Morgan, United-States
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Summary:
This paper describes the expected role of internal economic capital models in Solvency II and discusses the case for their use. Practice has been developed by leading insurance companies, which have followed different approaches to building internal capital models, and we give an overview of the key methodological issues. These include, for example, the risk measure to use, the type of liability valuation (statutory or market consistent), the time horizon and the acceptable probability of ruin The authors have developed and implemented such an internal economic capital model for a major US insurer, using nested stochastic projections.Stochastic projections are inherently complex; require long runtimes and results are difficult to analyze. Nested stochastic projections are far more complex because of the additional scenarios run at future durations. Any application which involves projecting forward stochastically a realistic balance sheet (i.e. with liabilities valued on a market consistent basis) will theoretically involve nested stochastic projections. Whilst approximations can be used to avoid nested stochastic modeling, these generally have limitations which can reduce the value of the work.We have encountered challenges and problems in this modeling. The paper describes how we have dealt with them and the insights gained. Challenges include the complex, dynamic interactions required, IT issues (both software and hardware) and the need to compress the model to get manageable performance, while still having results which can be understood and analysed (avoiding “black boxes”).Our observations also have applicability to other regulatory and financial reporting developments such as European Embedded Value, UK ICAs and the developing International Financial Reporting Standards.The authors have developed and implemented such an internal economic capital model for a major US insurer, using nested stochastic projections.Stochastic projections are inherently complex; require long runtimes and results are difficult to analyze. Nested stochastic projections are far more complex because of the additional scenarios run at future durations. Any application which involves projecting forward stochastically a realistic balance sheet (i.e. with liabilities valued on a market consistent basis) will theoretically involve nested stochastic projections. Whilst approximations can be used to avoid nested stochastic modeling, these generally have limitations which can reduce the value of the work.We have encountered challenges and problems in this modeling. The paper describes how we have dealt with them and the insights gained. Challenges include the complex, dynamic interactions required, IT issues (both software and hardware) and the need to compress the model to get manageable performance, while still having results which can be understood and analysed (avoiding “black boxes”).Our observations also have applicability to other regulatory and financial reporting developments such as European Embedded Value, UK ICAs and the developing International Financial Reporting Standards.
 
Date: 1 June - Time: 14:15 to 15:45 - Room: 343
Theme: 1.A. Stochastic dependence